Firm’s decisionsFirm’s decisions

Lecture 26 – academic year 2014/15Introduction to Economics

Fabio Landini

What do we do today:What do we do today:

• A firm and its costsA firm and its costs

• Total, fixed and variable costsTotal, fixed and variable costs

• Average and marginal revenueAverage and marginal revenue

• How firm set optimal QHow firm set optimal Q

Firm behaviourFirm behaviour

We want to study firm behaviour in in presence of We want to study firm behaviour in in presence of different market structures (in this case mainly different market structures (in this case mainly perfect competition).perfect competition).

Firm’s aimFirm’s aim

The main objective of a firm is toThe main objective of a firm is to

maximize profitmaximize profit

ProfitProfit:: Total revenueTotal revenue (TR) minus (TR) minus

Total costTotal cost (TC) (TC)

Profit: revenue - costs Profit: revenue - costs

• RevenueRevenue:: amount that a firm earns amount that a firm earns through salesthrough sales

• CostsCosts:: Amount that a firm spends for Amount that a firm spends for factors of productionfactors of production

Opportunity costsOpportunity costs

Production costs include both Production costs include both explicit costsexplicit costs and and implicit costsimplicit costs::

• Explicit costsExplicit costs: monetary costs that are : monetary costs that are necessary to hire factors of production.necessary to hire factors of production.

• Implicit costsImplicit costs: costs that do not require any : costs that do not require any direct cash outlay.direct cash outlay.

Taken together we have Taken together we have opportunity costsopportunity costs

EconomistsEconomists: look at opportunity costs: look at opportunity costsAccountantsAccountants: look at explicit costs, but often : look at explicit costs, but often

neglect implicit costsneglect implicit costs

When the revenue is higher than both When the revenue is higher than both explicit costs and implicit costs the firm explicit costs and implicit costs the firm makes economic profitmakes economic profit

Opportunity costsOpportunity costs

• Average taxes paid by undergraduate students during the first 4 years (data 2003-04): 2.178 euro.

• Other direct expenses to follow classes and write exams: 3.273 .• Foregone income (comparison with non-Univ. students): 65.838.• Total expenses: 71.739.• Income differential for university degree (wit respect to non-Univ. students,

computed during the first 40 years of activity): 134.000. • Value of university degree neat of its cost: (134.000-71.739) = 62.408• Average annual return of university degree: 9,9 %.

Source: Moro-Bisin, La laurea: un ottimo investimento, www.LaVoce.info, 24/10/2005.

Example: Is University enrolment a good investment in Italy?

Production functionProduction function

LabourLabour ProductionProduction

00 00

11 5050

22 9090

33 120120

44 140140

55 150150 0

20

40

60

80

100

120

140

160

0 1 2 3 4 5 6

It shows the relationship between the quantity of It shows the relationship between the quantity of production factors “efficiently employed” and the production factors “efficiently employed” and the quantity produced.quantity produced.

Important: it does not describe all possible Important: it does not describe all possible combinations between the quantity of production combinations between the quantity of production factors and final product.factors and final product.

But only. those without useless “waste”.But only. those without useless “waste”.

Example: if I can produce Example: if I can produce 10 units10 units of a good with of a good with 5 5 workersworkers or only or only 2 workers2 workers, the only point in the , the only point in the production function is (10, 2) (product=10, work=2), production function is (10, 2) (product=10, work=2), and not (10, 5).and not (10, 5).

(10, 5) is inefficient with respect to (10, 2)(10, 5) is inefficient with respect to (10, 2) ..

Production functionProduction function

• Marginal product (of labour)Marginal product (of labour)

Q obtained through L of Q obtained through L of one unitone unit

• Previous table:Previous table:

L=0 -> L=1 produces Q = 50L=0 -> L=1 produces Q = 50

L=1 -> L=2 produces L=1 -> L=2 produces Q = 40Q = 40

L=2 -> L=3 produces Q=30L=2 -> L=3 produces Q=30

And so on….And so on….

Production functionProduction function

Marginal productMarginal product

From the table you can see that the marginal product is From the table you can see that the marginal product is always positive,always positive, but decreasing but decreasing

That is: if L increases:That is: if L increases:

• The level of production always increases(The level of production always increases(positivepositive marginal product), marginal product),

• However such an increase is smaller at the margin However such an increase is smaller at the margin ((decreasing decreasing marginal product)marginal product)

Why?Why?

Presence of fixed factors (e.g. congestion effects in using Presence of fixed factors (e.g. congestion effects in using a machine)a machine)

From production to costsFrom production to costsLabourLabour ProductionProduction Fixed Fixed

cost(maccost(machine)hine)

Variable Variable cost cost

(labour)(labour)

00 00 3030 00

11 5050 3030 1010

22 9090 3030 2020

33 120120 3030 3030

44 140140 3030 4040

55 150150 3030 5050

Total Total costcost

3030

4040

5050

6060

7070

8080

Curve of total costCurve of total cost

20

30

40

50

60

70

80

90

0 20 40 60 80 100 120 140 160

Produzione

Co

sto

to

tale

Total and marginal costTotal and marginal cost

• Marginal costMarginal cost

Total cost that derive from Q of Total cost that derive from Q of one unitone unit

Q -> total cost (i.e. marginal cost is Q -> total cost (i.e. marginal cost is positivepositive))

Moreover: the Total cost is greater at the Moreover: the Total cost is greater at the margin (marginal cost is margin (marginal cost is increasingincreasing))

Explanation: it depends on the structure of the Explanation: it depends on the structure of the production function (fixed factors)production function (fixed factors)

Relationship between MP and MCRelationship between MP and MC

0

10

20

30

40

50

60

0 1 2 3 4 5 6

Lavoro

Prodo

tto m

argina

le

0.00

0.20

0.40

0.60

0.80

1.00

1.20

0 20 40 60 80 100 120 140 160

Produzione

Costo

marg

inale

Average cost and marginal costAverage cost and marginal cost

• Average costAverage cost: FC, VC, TC over Q: FC, VC, TC over Q – Average fixed cost (AVFC)Average fixed cost (AVFC)– Average variable cost (AVVC)Average variable cost (AVVC)– Average total cost (AVC)Average total cost (AVC)

• Marginal costMarginal cost– Increase in TC if ΔQ=1Increase in TC if ΔQ=1– Equal to: ΔCT/ΔQEqual to: ΔCT/ΔQ

• The firm consider both The firm consider both AVC AVC andand MC MC to take to take her production decisionher production decision

Co

st (

in e

uro

)

Quantity

The U-shaped AVCThe U-shaped AVC

AVC

Q*

Costs (pp. 220)Costs (pp. 220)

Produz.Produz. FCFC

VCVC

00 33 00

11 33 0,30,3

22 33 0,80,8

3…3… 33 1,51,5

……88 33 8,08,0

99 33 9,99,9

TCTC

33

3,33,3

3,83,8

4,54,5

11,011,0

12,912,9

AVFCAVFC

--

33

1,51,5

11

0,380,38

0,330,33

AVVCAVVC

--

0,30,3

0,40,4

0,50,5

1,01,0

1,11,1

Costs (pp. 220)Costs (pp. 220)

MCMC

0,30,3

0,50,5

0,70,7

1,71,7

1,91,9

AVCAVC

3,33,3

1,91,9

1,51,5

1,381,38

1,431,43

Produz.Produz. FCFC

VCVC

00 33 00

11 33 0,30,3

22 33 0,80,8

3…3… 33 1,51,5

……88 33 8,08,0

99 33 9,99,9

TCTC

33

3,33,3

3,83,8

4,54,5

11,011,0

12,912,9

Shape of AVCShape of AVCWhy is AVC U-shaped?Why is AVC U-shaped?

• Because it is the sum of AVFC and AVVCBecause it is the sum of AVFC and AVVC– AVFC is decreasing with respect to QAVFC is decreasing with respect to Q– AVVC is increasing with respect to QAVVC is increasing with respect to Q

Co

sto

(in

eu

ro)

Quantità

AVC

AVVC

AVFC

Production in perfect competitionProduction in perfect competition

• Given this cost structure, how does a firm decide Given this cost structure, how does a firm decide the quantity to be produced?the quantity to be produced?

• Let’s study this problem in a perfectly competitive Let’s study this problem in a perfectly competitive marketmarket

• Characteristics:Characteristics: Many sellers and buyersMany sellers and buyers

Product are perfect substituteProduct are perfect substitute

Free entryFree entry

• Consequences:Consequences: firms are firms are price takerprice taker

Price and revenuePrice and revenue

QQ PricePrice TR = PxQTR = PxQAVR=AVR=

TR/QTR/Q

11 66 66 66

22 66 1212 66

33 66 1818 66

44 66 2424 66

MR = MR = ΔTR/ΔQΔTR/ΔQ

66

66

66

66

Firm’s revenue in perfect Firm’s revenue in perfect competitioncompetition

In a perfectly competitive market:In a perfectly competitive market:

MR = priceMR = price

NB: This is not true in other market structuresNB: This is not true in other market structures

Profit maximizationProfit maximization

Firm’s objective = max profitFirm’s objective = max profit i.e.: set Q such that the difference between TR i.e.: set Q such that the difference between TR and TC is max and TC is max

• This happens when the firm set Q such that This happens when the firm set Q such that MR = MCMR = MCIf If MR > MCMR > MC,, an increase in an increase in Q Q increases profitincreases profit

If If MR < MCMR < MC, , an increase in an increase in Q Q reduces profitreduces profit

If If MR = MCMR = MC, , profit is maxprofit is max

Firm production decisionFirm production decision

Quantity0

Price

AVCMC

Firm production decisionFirm production decision

Quantity0

Price

AVCMC

P = AVR = MRP

Firm production decisionFirm production decision

Quantity0

Price

AVCMC

P = AVR = MRP

Profit max Q

Q

Firm production decisionFirm production decision

Quantity0

Price

AVCMC

P = AVR = MRP

AVC

Profit max Q

Q

Firm production decisionFirm production decision

Quantity0

Price

AVCMC

P = AVR = MRP

AVC

Profit max Q

Q

Profit

What happens in with free entry?What happens in with free entry?

Quantity0

Price

AVCMC

P = AVR = MRP

Q

The existence of a positive profit will lead more The existence of a positive profit will lead more firm to enter -> in supply -> pricefirm to enter -> in supply -> price

Quantity0

Price

AVCMC

P = AVR = MRP

Q

The existence of a positive profit will lead more The existence of a positive profit will lead more firm to enter -> in supply -> pricefirm to enter -> in supply -> price

Quantity0

Price

AVCMC

P = AVR = MRP

Q

P’ = AVR’ = MR’P’

Q’

The existence of a positive profit will lead more The existence of a positive profit will lead more firm to enter -> in supply -> pricefirm to enter -> in supply -> price

Quantity0

Price

AVCMC

P = AVR = MRP

Q

P’ = AVR’ = MR’P’

Q’

P’’ = AVR’’ = MR’’P’’

Q’’

As soon as profit=0 no firm will enter any more… As soon as profit=0 no firm will enter any more…

Quantity0

Price

AVCMC

P = AVR = MRP

Q

P’ = AVR’ = MR’P’

Q’

P’’ = AVR’’ = MR’’P’’

Q’’

ConclusionConclusion

We studied tools that firms use to take We studied tools that firms use to take decisiondecision

Firms set profit set Q so that MR=MC, i.e. max Firms set profit set Q so that MR=MC, i.e. max profitprofit

If there is free entry in the market profit tends If there is free entry in the market profit tends to zero in the long periodto zero in the long period